A cut in India's sovereign rating to junk status may threaten the nation's chances of being added to global bond indexes, steepen the bond yield curve and weaken the rupee, according to UBS Group AG.
The Swiss bank expects S&P Global Ratings and Fitch Ratings to lower their outlook on the rating to negative from stable over the next couple of months, strategists led by Rohit Arora wrote in a June 3 note.
Earlier this week, Moody's Investors Service cut India's rating to the lowest investment grade, putting it on par with S&P and Fitch at a level above high-yield.
Here are some scenarios from the UBS analysis:
A Threat to Bond Index Inclusion
India's aim to be part of global bond indexes will likely be undermined if two raters downgrade the nation's rating. While a possible addition to JPMorgan's GBI-EM won't be impacted, the chances of being included in FTSE's WGBI and Bloomberg Barclays' Global Aggregate Index might come undone.
Limited Portfolio Outflows
With India not being part of major bond index, there's no mechanical pass-through of a rating cut to foreign outflows in debt. Currently, overseas investors hold about $40 billion in sovereign and corporate rupee debt. If 20%-30% of that is rating sensitive, a downgrade could lead to outflows of about $10 billion. That would be 2.5% of forex reserves and will have a negligible impact.
Structurally High Term Premia
As markets move from investment to speculative grade, term premia increase non-linearly, and the impact on the curve shape could be long lasting. India's sovereign bond yield curve has been gradually steepening since 2015 amid worsening fiscal situation and declining household savings. The 2- and 10-year spread steepening trend may continue and could hit 2010 high of 250 basis points in FY21.
Debt flows in India have risen in prominence, with the cumulative balance of payments debt flows running at twice the equity flows since 2014. A structural decline in this could hurt the rupee when the current account again slips to a deficit. Higher credit default swap rates would mean a higher cost of external borrowing or a decline in those borrowings and eventual capital outflows. That may hurt the rupee via both the channels.
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